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Tutorial 3 Interest Rates

The document summarizes key concepts related to interest rates including: - The term structure refers to the relationship between interest rates and maturities of similar securities. - The expectations theory postulates that the term structure is based on expectations of future inflation rates. - A downward sloping or inverted yield curve occurs when long-term rates are higher than short-term rates. - If expecting an economic boom, a firm needing to borrow should issue long-term rather than short-term debt.

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85 views4 pages

Tutorial 3 Interest Rates

The document summarizes key concepts related to interest rates including: - The term structure refers to the relationship between interest rates and maturities of similar securities. - The expectations theory postulates that the term structure is based on expectations of future inflation rates. - A downward sloping or inverted yield curve occurs when long-term rates are higher than short-term rates. - If expecting an economic boom, a firm needing to borrow should issue long-term rather than short-term debt.

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FIN5FMA - FINANCIAL MANAGEMENT

TUTORIAL 3 – INTEREST RATES

Part 1: Identify whether the following statement is TRUE or FALSE. Correct the false statement.

1. The term structure is defined as the relationship between interest rates and maturities of
similar securities.

2. The expectations theory postulates that the term structure of interest rates is based on
expectations regarding future inflation rates.

3. The yield curve is downward sloping, or inverted, if the long-term rates are higher than the
shortterm rates.

4. If you have information that a recession is ending, and the economy is about to enter a
boom, and your firm needs to borrow money, it should probably issue long-term rather than short-
term debt.

5. Bonds with higher liquidity will demand higher interest rates in the market since they can be
easily converted into cash on short notice at or near the fair market value for that bond.

Part 2: Exercises

1. Yield curves

A. Plot a yield curve based on these data.


B. What type of yield curve is shown?
C. What information does this graph tell you?
D. Based on this yield curve, if you needed to borrow money for longer than 1 year, would it make
sense for you to borrow short term and renew the loan or borrow long term? Explain
2. A Treasury bond that matures in 10 years has a yield of 6%. A 10-year corporate bond has a
yield of 8%. Assume that the liquidity premium on the corporate bond is 0.5%. What is the default
risk premium on the corporate bond?
3. Due to a recession, expected inflation this year is only 3%. However, the inflation rate in Year
2 and thereafter is expected to be constant at some level above 3%. Assume that the expectations
theory holds and the real risk-free rate (r*) is 2%. If the yield on 3-year Treasury bonds equals the
1year yield plus 2%, what inflation rate is expected after Year 1?

yield on 1-year bond, r1 = 3% + 2% = 5%; yield on 3-year bond, r3 = 5% + 2% = 7% = r* + IP3; IP3 =


5%; IP3 = (3% + x + x) / 3 = 5%, x = 6%

4. An investor in Treasury securities expects inflation to be 2.5% in Year 1, 3.2% in Year 2, and
3.6% each year thereafter. Assume that the real risk-free rate is 2.75% and that this rate will remain
constant. Three-year Treasury securities yield 6.25%, while 5-year Treasury securities yield 6.80%.
What is the difference in the maturity risk premiums (MRPs) on the two securities; that is, what is
MRP5–MRP3?
IP3 = (2.5%+3.2%+3.6%)/3=3.1%; IP5 = (2.5%+3.2%+3.6%*3)/5=3.3%; Yield on 3-year bond,
r3=2.75%+3.1%+MRP3=6.25%, so MRP3=0.4%; Yield on 5-year bond, r5=2.75%+3.3%+MRP5=6.8%,
so MRP5=0.75%; Therefore, MRP5 - MRP3 = 0.35%

5. The yield on 1-year Treasury securities is 6%, 2-year securities yield 6.2%, and 3-year
securities yield 6.3%. There is no maturity risk premium. Using expectations theory, forecast the
yields on the following securities:

a. A 1-year security, 1 year from now


b. A 1-year security, 2 years from now
c. A 2-year security, 1 year from now

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